A Review of Passenger Rail Franchising in Britain: 1996/1997–2011/2012

John Preston

Workshop on Tendering Transport Services

Madrid, 19 May 2014. Outline

Update of a paper in Research in Transportation Economics in 2008.

• Brief History of Franchising.

• Key Trends.

• Key Issues: Competition, Objectives, Overoptimistic bids.

• Franchising Futures.

• Conclusions

2 A Very Brief History of Rail Franchising in Britain • First phase. 1996/7 – c2000. Associated with OPRAF. 25 TOCs franchised. • Second phase. c2001-2004. Associated with SRA. 9 TOCs (re)-franchised. • Third phase. 2005-12. Associated with DfT. 13 TOCs (re)- franchised. 2012. ‘Failure’ of West Coast Franchise and instigation of the Laidlaw Enquiry and Brown Review. • Fourth phase. 2014- 3 Development of the Franchises Original Franchise Type Development and Franchisees Present/Future Franchise 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Lon Stagecoach Stagecoach ? South Western

Island Line Reg Stagecoach

MTL was purchased by in 2000 Electrics Reg MTLArr iva /Abellio Merseyrail

2008: Laing Rail, owner of M40, was purchased by DB Regio. 2011: Re‐organisation to Arriva UK. Lon M40 Trains M40 Trains DB Regio Arriva Chiltern Railways

Connex South Eastern Lon Connex () SRA ? Integrated New name: Northern Spirit MTL was purchased by Arriva in 2000 Franchise North East Reg MTLArr iva Serco/Abellio ? Northern

North Western Reg First Serco/Abellio ? TransPennine

New name: Wales & Borders Railways Reg PrismNational Express Arriva ? Prism was purchased by in 2000 New name: Wales & West Reg Prism National Express

Great Western IC First First ? Greater Western

Thames Trains Lon Go‐Ahead First

Midland Main Line IC National Express Stagecoach ?

Some services to Reg National Express New Cross Country

New name: North / Lon National Express Govia ? Some services went to ‘‘ franchise in 2007 New name: New Cross Country Cross Country IC Virgin Arriva ? New Cross Country

West Coast Trains IC Virgin ? West Coast

Scotrail Reg National Express First ? ScotRail

Prism was purchased by National Express in 2000 New name: Essex LTS Rail Lon Prism National Express / ? c2c/

Great North Eastern IC Sea Containers NEX East Coast ? East Coast GB Railways was purchased by First in 2003 Anglia Reg GB Railways Brand name ‘One’ New name: Greater Anglia Great Eastern Lon First National Express Abellio ? Greater Anglia Prism was purchased by National Express in 2000 West Anglia Great Northern Lon Prism National Express , Southern Thameslink Lon Govia First ? and Great Northern Reg National Express New name: Southern Publicly operated Connex (Veolia) Govia Govia Connex South Central Lon Re‐Negotiation / Cost‐plus contract Regional Long Distance London & South East 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Start of franchise contract Source: Schneider, 2013, after DfT 2013, Knowles 2004, Müller 2011, Nash/Smith 2007 British Rail Regulation 1993 ‐

Franchise rounds I II III IV 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2013 2014

OPRAF SRA DfT

Franchising Act Act

Office of Strategic Rail Passenger Rail Franchising Authority

Railways Welsh Assembly Transport

Transport for London Government Railways Act

1993

Regulation of fare levels 2000 Transport Merseyside PTE 2005

Shadow‐SRA SSRA Regionalised responsibility for some franchises Strategic planning Rail

Railtrack ‐ Department for Act Public Members Transport facto placed into De Infrastructure manager alisation administration Renation Railways

Privatised 1993

Office of Rail Regulation ORR

Safety Regulation Rail Safety and Standards Board RSSB (since 2003)

at Health and Safety Executive Act etc. and 1974 Work Safety

Health Her Majesty's Railway Inspectorate Her Majesty's Railway Inspectorate Safety Inspectorate

Act

Office of the Rail Regulator Railways

Transport Competition Act Monopoly regulation OFT 1993 Office of the International Rail Regulator Safety Commission Railways Office of Fair Trading and OIRR 2003

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2013 2014 ‘Moderation of Competition’ stages Open Access restricted to Open Access restricted to Case‐by‐case approach. Generally origin‐destination‐pairs 20% of a franchisee’s speaking: Open access services have to that constitute less than registered revenue flows demonstrate that they are not primarily 0.2% of a franchisee‘s – unregistered flows open abstractive but generative. It seems as if revenue for competition. the relevant threshold is that not more than 30% of the traffic is abstractive.

Source: Schneider, 2013, after Knowles 2004, Müller 2011, Nash/Smith 2007, Nash/Smith 2011, Preston 2008

Trends: Passenger Kms

55 50 45 40 35 30 Passenger Kms (Billion Kms) 25 20 1995/6 – 00/1 +27%

Passenger Kms Passenger 15 10 2001/2 – 04/5 +9% 5 2005/6 – 11/12 +33% 0 Total +84% /2 0 /2 81 83 9/ 9 87/8 97/8 07/8 19 1 9 89/90991 993/4 9 99 001 003/4 0 09/10 1985/61 1 1 1995/61 1 2 2 2005/62 19 20 Year

Data from ORR Trends http://dataportal.orr.gov.uk/ Trends: Train Kms 600

500

400 s

300 Train Kms (Millions)

Train Km 200

100 1995/6 – 00/1 +21% 2000/1 – 04/5 +7% 0 2005/6 – 11/12 +13% 1 4 Total +46% 98 98 7/8 1 1 8 90/1 3/4 /6 /9 9 02/3 5 8 19 19 19 1996/7 1999/0 20 200 200 Year Trends: Unit Costs

Source: Robins, 2012. Unit costs in £ per train km, 2008 prices. Main growth in Renewals and Enhancements, but also

increases in TOC costs since 2000. 9 Trends: Government Support

1995/6 – 00/1 -44% 2001/2 – 04/5 +150%

2005/6 – 11/12 -24% Total +6%

10 Estimated Welfare Effects (£ B)

Overall Increase in Net Effect Infrastructure Costs 1995/6 -2.2 +4.6 +2.4 – 2000/1 2001/2 -18.7 +16.9 -1.8 – 2004/5 2005/6 -13.8 +17.0 +3.2 – 2008/9 Total -34.7 +38.5 +3.8

Based on Robins (2012) and Preston and Robins (2013). If each franchise had bidding costs of £22.5M then the net benefits of £3.8B are offset by transaction costs of £1.1B. 11 Issue (I) Level of Competition and the Winning Bid Franchising has been competitive, but competition declining over time:

• First phase: 5.4 bids per franchise

• Second phase: 4.2 bids per franchise

• Third phase: 3.8 bids per franchise. Current pool of 10 active bidders. High bidding costs (£5M per bidder in 2006, £10M in 2012).

Are rail franchises a common value or a private value auction? Assuming no uncertainty and/or no risk aversion contracting- out will ensure optimal effort. But where there is uncertainty (e.g. open access) and risk aversion, effort will be sub-optimal.12 Issue (I) Level of Competition and the Winning Bid

Only 3 out of 47 franchises have failed. However, 13 franchises re- negotiated after Hatfield 2000. Evidence of the winner’s curse?

13 Issue (II) Objectives What is franchising trying to achieve?

(i) To harness private sector commercial judgement and innovation to reduce the net cost and increase the value for money achieved from the

Government’s overall support for passenger rail services.

(ii) To improve passenger services, commensurate with funding available.

(iii) To set the level of service needed and to vary specifications to reflect changing market needs and accommodate future passenger growth.

(iv) To protect passengers from the power of unregulated monopolies.

(v) To maximise the benefits of the network as a whole.

(vi) To fit rail within Government’s wider objectives.

Maximise net social benefit subject to a budget 14 constraint? Issue (II) Objectives Brown Review:

(i) Ensure value for money by competition for the market.

(ii) Harness private sector skills and innovation.

(iii) Ensure stability of service.

(iv) Secure franchisees who will work in partnership.

(v) Facilitate further devolution of decision making.

(vi) Ensure services are delivered and managed by organisations which are attuned to local market needs.

15 Issue (II) Objectives (continued)

Change in: Fares Train Miles Subsidy Welfare Profit Max - +17% -8% -7% -22% 50% variable Constrained -1% +8% 0 0 Welfare Max - 50% variable Unconstrained -93% +71% +521% +86% Welfare Max - 50% variable Profit Max - +24% -47% -89% -35% 100% variable Constrained -36% -30% 0 +25% Welfare Max - 100% variable Unconstrained -88% +12% +374% +53% Welfare Max - 100% variable

BCR of revenue support (£1.2 b per year) ≈ 4. BCR of revenue and direct support (£4.6b per year) ≈ 1.1

16 Issue (II) Objectives (cont.) Social v Commercial

2012-13 subsidy per passenger kilometre (pence) source: ORR data portal (northern/tpe adjusted for net subsidy) 15,0

12,0

9,0

6,0

3,0 pence per km

0,0

-3,0

-6,0 Issue (III) Overoptimistic Bids

The East Coast Franchise

Date Started Expected PVNP PVNP Duration 1st year Final year (£m) (£m) GNER April 1996 7 years 651 0

GNER May 2005 10 years (50) (219)

National Dec. 2007 7 ¼ years 7 (311) Comparison of FWC Express (purple) and NXEC (red) PVNP = Present Value of Net Payments. Figures in brackets bids. denote premia paid. Source: Modern 1Out-turn. Railways, 2012. Source: Preston and Root (1999) and www.dft.gov.uk

18 Issue (III) Overoptimistic

Bids

£200

South Eastern £100 South Western First Greater Western £0

-£100

Amount (£m) -£200

-£300

-£400

-£500 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 South Eastern £140 £114 £100 £126 £108 £65 £25 -£9 South Western £16 £64 £25 -£41 -£86 -£140 -£198 -£248 -£296 -£343 -£332 First Greater Western £97 £47 £15 -£20 -£111 -£168 -£233 -£302 -£364 -£428 First Capital Connect -£14 -£44 -£65 -£83 -£103 -£126 -£150 -£178 -£205 Year Date Started Expected PVNP PVNP Duration 1st year Final year (£m) (£m) Greater Anglia April 2004 10 years (19) (116) South Western Feb 2007 10 years 16 (235) Southeastern April 2006 8 years 135 (11) Great Western April 2006 10 years 95 (313) Capital Connect April 2006 9 years (14) (156) 19 TOTAL 163 (1050) Issue (III) Overoptimistic Bids (cont.) Cap and collar regime intended to promote efficient bidding given concern that post Hatfield bidders would be overly risk averse: - 50% of any fares revenues in excess of 102% of the TOC’s original forecasts are shared with DfT; - DfT makes a contribution equivalent to 50% of any revenue shortfall below 98% of the TOC’s original forecast - For any short fall below 96%, DfT’s contribution increases to 80%. However, seems to have led to strategic behaviour, although extreme gaming behaviour should be detected at the bid evaluation stage.

20 Issue (III) Overoptimistic Bids (cont.) West Coast franchise replaced the cap and collar regime but with bidders required to have in place a subordinated loan facility (SLF) to be drawn upon in case of default.

21/01/12 ITT issued

15/08/12 Intention to award to First Group

03/10/12 Cancellation of franchise and suspension of programme.

Laidlaw Enquiry highlighted (i) lack of transparency with SLF process (ii) technical mistakes in the calculation of the SLF (iii) contributory factors relating to lack of planning resource. 21 Brown Review: Key Themes 1. Exposure to macro-economic factors.

2. Overoptimistic bids.

3. Trend towards tighter franchise specifications and less flexible management.

4. Trend towards fewer, larger franchises.

5. Reduced ability of franchises to adapt.

6. Asymmetry between the experience and capability of bidders and that of the DfT franchising team.

22 Alternative Contract Specifications • ‘Commercial’ franchises (long distance services): longer length, looser specification, remain net subsidy. • ‘Social’ franchises (short distance commuter and regional services): shorter length, tighter specification, gross cost. • Experimentation with vertical re-integration, micro- franchises, Vickrey auctions and contracting out of planning function. • Brown favours 7 to 10 years franchises, with a 3 to 5 years continuation mechanism. Management contracts where major upheavals. Concessions where authority has marketing capabilities. Against cross default provisions. • Some calls for re-nationalisation via DOR. 23 Franchising Futures – process

• DfT tells the market ITT what it wants to buy

• Bidders forecast the revenues and costs Bid which their delivery of the franchise will preparation drive

• Bidders decide how much of the Bid surplus money (Revenues less costs) Submission it will “bid” back to the DfT in Premium.

• Bidders are contracted to Franchise deliver the Premium as bid life (Regardless of actual revenue and costs).

24 Franchising Futures – Key components

Risk Capital Profit allocation requirements

Revenue risk Parent Company Profit above a Support given level Cost risk (Guarantee) shared with DfT Profit risk Performance bond Regulatory risk

Inflation risk Profit cap Season ticket Open access bond risk

25 Franchising Futures: Parent Company Support (PCS) The PCS requirement will be proportional to bid “ambition” above a certain level.

In this example, a bidder would be required to provide a minimum PCS of £30m, with bids above £1bn requiring additional PCS at a rate of £100k for every additional £1m bid. 26 Financial Futures: Risk Allocation

For some franchises, the DfT may offer to share some or all financial risk with a franchisee.

The design of the risk sharing arrangement will depend on the characteristics of the particular franchise and will affect TOC financial stability and incentives.

A few ways of doing this are set out below:

Management All risk with the contract TOC e.g. West Increasing risk with the TOC e.g. Essex Coast Thameside

“cap & collar” GDP based (a special case of mechanism revenue share & Cost risk with the Revenue share & e.g. Future support) TOC, revenue risk support East Coast e.g. with DfT e.g. Greater Southern e.g. Anglia Thameslink

27 Risk allocation – an illustration

Revenue share line Revenue Target Revenue

Revenue support line revenue No revenue support for support for shortfall Actual shortfall revenue

TOC not yet eligible TOC eligible for for revenue share Revenue share Time

28 Conclusions

• Service requirements not stable – large growth.

• Some technology issues.

• Some sunk costs.

• Some issues concerning definition and letting of the contracts.

• Some difficulties in enforcing service delivery.

Further refinements of the franchising process likely.

The DfT are indicating a ‘horses for courses’ approach but which horse for which course?

29